Frontier Markets For Dummies
Frontier markets are less-developed economies not included in either the MSCI World Index of Developed Countries or the MSCI Emerging Markets Index. Frontier markets are considered a subset of emerging markets, and they offer you, the investor, the opportunity to make returns similar to those delivered by the major emerging markets over the last decade. Investing in frontier markets involves a fair amount of risk, so it's essential that you work with a financial advisor to make the right investment decisions for your particular situation.
The Major Characteristics of Frontier Markets
For an investor, frontier markets are where the major emerging markets were 12 to 15 years ago in terms of GDP growth, structure of their economies, and valuations. The largest and poorest frontier economies have very young populations, a low level of urbanization, and are generally embracing economic reforms. The major advantage of frontier markets that makes it likely that they will perform as well as emerging markets have over the last 10 to 15 years is that they have the same characteristics now as the major emerging markets had earlier but still sell at reasonable valuations.
These characteristics include but are not limited to the following:
Young populations that are growing rapidly
Birth rates that, while still healthy, have declined somewhat
Low levels of urbanization leading to migration from the countryside to the cities
Growing middle classes as incomes rise
Rapid economic growth producing rising living standards
Low levels of internal and foreign debt
Governments pursuing policies of liberalization and reform
The removal of trade barriers through the free trade agreements and reductions in tariff and customs duties
Frontier Market Risks
Frontier market investments do have risks. It is often recommended that these markets comprise between 5 and 10 percent of your total international equity holdings as a baseline weighting.
There are four main types of risk baked into many types of investments, including those based in frontier markets: investment risk, political and social risk, currency risk, and liquidity risk.
Investment risk refers to the hazards specifically connected to the shares of a specific company:
The quality of management
The company's preeminence (or lack of it) in its product sector
The effect of the company's debt load
The company's relationships with its stakeholders such as unions and customers
The presence or absence of barriers to the entry of competitors
The company's ability to keep a healthy pipeline of products being readied to come to market
The company's risk management capabilities
Political and social risk
Political and social risk refers to factors that are not directly connected to the company but are sufficiently strong in the surrounding environment to have an impact on its fortunes. These include the following:
The rule of law. Knowing that the rules that govern how your investment is treated will be followed and that contracts signed by the company in which you've bought shares will be honored is one of the most important factors to consider when investing in a country or region. It's noticeable that the majority of the Frontier Markets considered attractive usually have common law systems like the United Kingdom and the United States.
The country's stability. Formerly unstable African nations are now considered much more stable then decades earlier.
The presence or absence of militant groups. If we use the Middle East as an example, at the time of writing, Egypt, Syria, Lebanon, and Libya were embroiled in political crises but the United Arab Emirates, Qatar, and several other nations in the region are stable investment destinations.
The proximity to countries in crisis. At the time of writing, Turkey was relatively stable politically and socially but its economy appeared threatened by the influx of refugees from Syria.
The presence or absence of corruption in senior levels of government.
Currency risk refers to the potential for costs when transactions involve more than one currency. These risks can occur in several ways:
Through the company's own transactions
Through whether it retains revenues in a foreign market or repatriates them to its home market such as the United States
Through charges levied by financial institutions involved in the transactions
Through the exposure of a country's currency to speculation
Liquidity risk refers to the ease or difficulty, speed, and complexity involved in transactions. Most Frontier and some Emerging markets are still relatively illiquid, meaning that it is difficult to buy large amounts of equities quickly and almost impossible to sell them quickly. One of the major issues for investors in these markets is the settlement of trades on the stock market. Many countries lack a central electronic market, and trades have to be settled by the movement of physical stock certificates between parties to the transaction.
Then there are issues with finding suitable custodian banks to hold the shares in the company once they have been bought. Usually it is not practical for investors to begin trading in these markets until a major international bank such as Citigroup or HSBC provides a custodian service, which guarantees that an investor actually has ownership of shares that they have purchased.